Not All Bear Markets Are Created Equal

We’ve recently changed our cyclical view, as we don’t think the recent downdraft we’ve been experiencing is over yet. In fact, while many believe we’re experiencing a ‘garden variety pullback’ that provides us with a buying opportunity, we believe there’s a growing probability that the long running cyclical bull market may be transitioning into a cyclical bear market. We could be wrong—and hope that we are. But hope is not a strategy and we need to align with the evidence that calls for playing defense and protecting against a possible change in the market cycle.

A cyclical bear market may seem like bad news at first blush, but it’s really not a catastrophe from a big picture perspective. While most investors pursue long-term price appreciation, at some point prolonged bull markets make assets less attractive as prices get dislocated from underlying fundamentals. When markets hit that point, some form of correction helps purge complacency and elevated valuations, and helps set up great long term buying opportunities. Viewed through that lens, investors shouldn’t panic, but should embrace the occasional bear market as an ally in helping to build future wealth.

While we recognize that a long-term bear market is part of the natural cleansing process, our tactical strategies have an objective of minimizing downside risk when we believe a downturn is likely. Currently our investment discipline requires us to make portfolio adjustments in line with our market view and we are in the process of implementing changes throughout our strategies. We are not structured to make absolute returns, but we are structured to ‘lose less’ so that portfolios can spring back more quickly when a new bull market begins. If we do our job well, we will dampen volatility during this market downturn, and will know when to put risk back into portfolios to start compounding wealth again.

One of the key issues we’ll be considering during this market reset is how defensive we should get. After all, there have been many cyclical bear markets in history, and bear markets are not created equal. Some cyclical bear markets are short and shallow, while others are protracted and deep. In order to decide how much to modify our portfolios, we must have some sense of which type of bear market may unfold. This is a difficult and imprecise exercise since markets can sometimes overshoot and create negative feedback loops during times of stress. But though the task is challenging, there are some guide posts that can help us determine how much downside risk we should bake into our forecast.

One of the major factors that seems to affect the duration and magnitude of a cyclical bear market in the U.S. is whether or not the nation’s economy is heading into a recession. Ned Davis Research, a well-known independent research service, examined the Dow Jones Industrial Average since 1960 and concluded that not all bear markets (there have been 14 since 1960) are the same—most notably, the draw-down and duration is significantly harsher during a recessionary period.

Although we think severe problems abroad will lead to an economic slowdown in the U.S., we are not forecasting a recession. We believe that a non-economic cyclical bear market is unfolding, which means it has a higher likelihood of being short and shallow, versus long and deep. This nuanced and important detail will likely have an impact on how much volatility we pull out of our portfolios during the downturn. It also suggests that we’ll have to be extremely nimble in our view, and prepared to switch our volatility settings back to neutral when we think this bear market has run its course.

Author: Rick Vollaro

Rick Vollaro, CPA, joined Pinnacle Advisory Group in 2000 and became a partner in 2008. He’s an active member of Pinnacle’s management and executive teams, and serves as the firm’s Chief Investment Officer (CIO). Rick has been featured in a variety of publications, including The Wall Street Journal, the Wall Street Transcript, IndexUniverse, and Standard & Poor’s MarketScope Advisor. A popular speaker, he appeared most recently at IndexUniverse’s “2012 Inside Fixed Income” conference and on S&P Dow Jones Indices “Where Are We Now?” webinar. He has a bachelor’s degree in accounting from Fairfield University and is a non practicing Certified Public Accountant.READ RICK'S PROFILE HERE

Pinnacle Advisory Group is a private wealth management firm, founded in 1993 and headquartered in Columbia, Maryland, with offices in Miami and Naples, Florida. We work with more than 1250 families and manage over $2 billion in assets for clients both in the mid-Atlantic region, and around the world.
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